THE LIKELY IMPACT OF RISING FUEL COSTS:
I was just reading this very interesting article
from The Economist. The basic gist is that the Fed was right to keep the screws on interest rates, upping it to 3.75% because US and world inflation is on the rise. The Economist tut-tuts that this is a necessary thing to do:
"The Fed signalled this week that it intended to keep pushing interest rates higher. Despite 11 increases since June 2004, monetary policy is still loose. Using August's inflation figure, real interest rates are barely positive, while bond yields are lower than before the Fed started to raise rates. Such monetary laxity has been fuelling America's housing bubble—and now it risks feeding wider inflation."
Yes. I can see this argument, and I feel some sympathy for this argument. What caught my eye though, was the conclusion:
"The real worry with rising inflation expectations is less that they herald a surge in inflation than that they will limit the ability of the Fed or other central banks to cut interest rates if growth stumbles. It is commonly argued in America that if the housing bubble were to burst, and falling house prices threatened to choke consumer spending, the Fed would slash interest rates to prop up the economy, as it did after the stockmarket bubble popped in 2001-02. But then inflation was falling. Today, with inflation rising, the Fed would no longer have that option. If the economy hits trouble, investors and homebuyers should not expect to be bailed out again. "
What The Economist is saying is that a negative supply shock (like rising oil prices) will result in lower incomes and output in an economy, ceteris parabis. One tool of government used to counteract this (in the short-run) is to increase monetary liquidity, lowering interest rates to increase investment and consumption. Unfortunately, the lower production and incomes is a reality in the long run. After-all, we did have a negative supply shock, right? What happens is that in the long-run, prices rise, as more money follows a smaller number of goods. The outcome of this is inflation. If inflation is unexpected this means that workers will produce more goods for less real pay. Firms also get hurt as they struggle with workers over the size of the pie that each will get.
And this is where we find out what biases (OK, world-view, if you like) inhabit not just The Economist but also The Fed. You see, the alternative to inflation is to just bite the bullet, let prices rise, in a one-off way, and accept a lower standard of living all round, since my unchanged nominal wage now buys less than it used to. How do we get people to accept a real wage cut? By having some short-run unemployment above the norm. That is where increasing interest rates lead to less investment, more default on corporate debt, less consumption, and less economic activity.
One can do either approach. They get to the same place--in the end.
Thought experiment: Who/what does unexpected inflation hurt? Creditors and owners of long-term debt (like 30 year fixed interest rate mortgages. To the extent that variable rate mortgages exists, this problem is dissipated, since ARM's adjust to inflation with a small lag): Banks, mortgage debt holders, and the like--mainly rich folks. Who benefits: People who owe fixed interest rate debt. People like mortgage holders, credit card debtors, and the like. Mainly poor and middle class folks. Now , consider who gets hurt by the one-off real wage cut: Mainly poor and middle class folks. Who benefits? Holders of capital--mainly rich and upper middle class folks. Do we see a pattern here? Yes, it is true, as The Economist says that: "Policymakers now understand that rising inflation harms growth, and independent central banks are more likely to stamp on inflation swiftly." But isn't it also a tad convienient that the prescription of vhoice of the powers that be just also happens to favour the powers that be...